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Captive Insurers Likely to Grow in New York

by Richard S. Feldman and William M. Savino

Reprinted with permission from the April 15, 1998 issue of New York Law Journal

New York's Insurance and Tax Laws were amended as of the end of 1997 to permit certain businesses and groups of unaffiliated corporations to form captive insurance companies in the state. Since then, there already have been at least two captives formed here: Several weeks ago, the New York State Insurance Department licensed a subsidiary of the Metropolitan Transportation Authority as the state's first captive insurance company, and Columbus-McKennon Inc., a New York-based manufacturer, moved its existing captive from Tennessee to become the second company licensed as a captive insurer in New York.

Although Vermont currently has the most captives of any of the dozen or so states that now permit them to be created, New York's new law - which provides captives with a streamlined licensing process, separate regulatory structure, competitive tax rate, broad grant of authority to write almost all types of property/casualty coverage and minimal investment restrictions - together with New York's status as a world business center and the home to many large public companies, could help New York become the captive capital of the United States.

New York's new captive insurance company law reflects a growing trend away from traditional insurance toward alternative risk-financing techniques, including self-insurance, risk retention groups and captives. These and other alternatives resulted in $12 billion in lost premiums to insurance carriers in 1979, but more than $60 billion in lost premiums by the mid-1990s, according to a study by Hartford-based insurance industry researcher Conning & Co.

Since the early 1980s, in fact, most Fortune 1,000 companies have left the traditional market; insurance industry analyst A.M. Best believes that most of the others will eventually leave, too. The 70 percent of middle market companies, with annual revenue from $1 million to $750 million, that Conning & Co. says still buy traditional insurance products may not be far behind.

Growth in the alternative market has been fueled to a large extent by growth in the number of captive insurance companies that have been created recently. For example, the number of captives increased by almost 7 percent in 1996 alone. Businesses and other entities as varied as American Express, Chrysler Financial, Dow Chemical, Exxon, Fidelity Investments, Ford Motor Credit, General Electric, the Missouri Bar Association, the National League of Cities, the Ohio Bar Association, J.C. Penney and the Texas Bar Association now have their own captives.

Moreover, captives offer coverage in lines as diverse as auto warranty, medical malpractice, Workers' Compensation, directors and officers liability, lawyer and accountant professional liability and general liability.

Certainly the largest part of the alternative insurance market is self-insurance, which includes companies that purchase insurance with high deductibles. Self-insurers tend to believe that they can lower their insurance costs and gain control over claims and claim settlement while having an incentive to improve the management of their own risks. Although self-insurance is an important option for many companies, others find that they can achieve these goals - and more - by forming a captive.

For one thing, a company that owns a captive insurer may find substantial tax benefits as compared with self-insuring.

Generally speaking, a company may deduct, as a current expense, insurance premiums it pays to an insurance carrier. Moreover, when a carrier places funds in a loss reserve to pay a claim, it generally may deduct the amount of the reserve from its income for that year - even if it will not pay out any funds to a claimant for quite some time.

A self-insurer, however, has no premiums to deduct and may reduce its income only by amounts it actually pays to claimants, not by amounts it may put in any reserve.

By contrast, a company that owns a captive insurer may be able to deduct premiums it pays to that entity. Moreover, a captive should be able to deduct the funds it places in a loss reserve to be used for the payment of claims. This can provide a substantial financial benefit. Indeed, one actuary has calculated that a captive can produce annual tax savings of about 2 to 3 percent compared with self-insurance. He assumed, among other things,

Under this scenario, a company with more than $10 million in annual losses probably would find a captive yielding greater savings, because of the fixed nature of most of the costs.

Other Benefits

Companies also find other benefits to forming a captive insurer.

A captive can provide a company with access to reinsurers, which for the most part still remain unwilling to deal directly with purchasers. Captives also can provide certain kinds of insurance to employees as well as to businesses that sell, distribute or purchase a company's products, which a company that self-insures is not in a position to do.

Businesses often are required to maintain insurance by their lenders, other creditors, or government regulators. Although this obligation typically is not met through self-insurance, a company with a captive insurer will be able to meet such a requirement.

Finally, smaller companies simply may not be willing or able to self-insure. For them, captives provide an alternative to traditional insurance and give them an ability to become more involved with claims management and claims resolution than usual.

The president of a government-services contractor based in Marquette, Mich., was quoted in Best's Review recently as to why his company joined a captive: "Our aim was to have significant input in claims resolution," he said. In the Workers' Compensation area, "We get monthly loss runs so we can immediately get down there, talk to the employees and monitor their progress. Since we joined the captive we've settled three or four cases that could have been major cases if we hadn't gotten involved early. Commercial insurer cases would get to court before we had any input. It was very frustrating."

The New York Law

The New York law establishes certain requirements for creating a captive insurer.

It permits a company that has a net worth in excess of $100 million or that is a member of a holding company system with a net worth exceeding $100 million to form and operate a "pure" captive insurer. In addition, a group of unaffiliated companies that are engaged in similar or related businesses or activities may form a "group" captive insurer. Under the law, a captive may be organized as a stock or mutual insurer.

Once it is formed, a captive is required to apply to the Superintendent of Insurance for a license to engage in the captive insurance business. Such a license permits a captive to write almost all types of property/casualty coverage, with the exception of title, mortgage guaranty, and financial guaranty insurance, to cover risks of its parent company and affiliated companies (in the case of a pure captive) or to cover risks of the companies that comprise the insured group (in the case of a group captive). Captives are not permitted to offer life or health insurance but they may, through the use of "fronting" insurers, write workers' compensation and motor vehicle liability coverage.

To obtain a license, a captive need only file an application with the Superintendent of Insurance for his review and approval. The application must include a certified copy of the captive's charter and bylaws, a financial statement certified by two principal officers, a plan of operation (including an actuarial report prepared by a qualified independent actuary) and other statements or documents that may be required by the Superintendent.

In evaluating the plan of operation, the superintendent by statute is required to consider, among other things:

• the amount and liquidity of the captive's assets relative to the risks to be assumed;

• the adequacy of the expertise, experience and character of the person or persons who will manage the captive;

• the overall soundness of the plan and the projections contained therein;

• and the adequacy of the loss prevention programs of the captive's owners.

The statute establishes certain capital and surplus requirements for captives. A pure captive incorporated as a stock insurer must have no less than $250,000 of total surplus as regards policyholders, of which $100,000 must represent paid-in capital. A pure captive incorporated as a mutual insurer must have no less than $250,000 of total surplus as regards policyholders. A group captive incorporated as a stock insurer must have at least $500,000 of total surplus as regards policyholders, of which $200,000 must represent paid-in capital. And a group captive incorporated as a mutual insurer must have at least $500,000 of total surplus as regards policyholders.

The minimum capital and surplus is required to be in the form of cash, certain specified investments or an irrevocable letter of credit.

A captive insurer is required to meet other statutory requirements under the law, including that it must:

• hold at least one meeting of the board of directors (which needs to have atleast three members, at least two of whom are New York residents) in New York every year,

• maintain its principal office and its records in New York, and

• use a captive manager (such as a licensed insurance agent or broker) resident in this state.

As might be expected, the law also contains certain requirements for captives relating to the filing of annual reports and the like.

Significantly, captives are subject to no restrictions on allowable investments with the exception that a group captive may not make loans to the companies that own it. A pure captive is specifically permitted by the statute to make loans to its parent company or affiliates with the prior approval of the Superintendent, except that loans of minimum capital and surplus funds are prohibited. In addition, a captive may assume risks of any other insurance carrier, provided the reinsurance premiums assumed do not exceed 50 percent of the gross premiums written by the assuming captive insurance company in any calendar year.

Conclusion

New York, a state well known for its hospitable insurance environment, has taken an important step forward to become a major domicile for captive insurers. It would not be surprising if large, sophisticated companies begin to relocate their existing captives to new York and if smaller companies begin forming their own captives here in the very near future.

Richard S. Feldman can be reached at richard.feldman@rivkin.com

William M. Savino can be reached at william.savino@rivkin.com

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